Krugman takes on MMT.
Let’s have a more or less concrete example. Suppose that at some future date — a date at which private demand for funds has revived, so that there are lending opportunities — the US government has committed itself to spending equal to 27 percent of GDP, while the tax laws only lead to 17 percent of GDP in revenues. And consider what happens in that case under two scenarios. In the first, investors believe that the government will eventually raise revenue and/or cut spending, and are willing to lend enough to cover the deficit. In the second, for whatever reason, investors refuse to buy US bonds.
“Investors” don’t buy bonds because they believe or do not believe in future primary surpluses. They price the bonds, and they do so based on arbitrage. If the central bank is setting a rate 3%, then bonds will be attractive to purchase if they yield a rate in excess of that, when adjusted for risk.
The second case poses no problem, say the MMTers, or at least no worse problem than the first: the US government can simply issue money, crediting it to banks, to pay its bills.
But what happens next?
We’re assuming that there are lending opportunities out there, so the banks won’t leave their newly acquired reserves sitting idle;
Here is the second problem: We are assuming that there are lending opportunities out there. What on earth does that mean? Except for extreme circumstances — e.g. a credit crunch/increasing perceptions of risk — Banks lend as much as the market is willing to borrow at all times, at the given rate, which is controlled by the central bank. Banks post the rate, and borrowers borrow all they want at that rate. Therefore Krugman is assuming that the demand for borrowing is shifting to the right while the rate remains fixed. Why? And even if it does, the government can respond by increasing the lending rate.
The lending rate is not a function of the quantity of reserves, it is a function of the marginal price of reserves, but the marginal price of reserves can be set independently of the quantity of reserves. For example, Canada does this by paying one rate on reserves and charging another rate for lending reserves. The rates it pays or charges are not constrained by the total quantity of reserves.
they’ll convert them into currency, which they lend to individuals.
No, banks do not “lend currency”. Currency is paper notes and coins. Currency is created when a household makes a withdrawal from a bank, converting its deposit into currency, in which case the bank purchases currency with its reserves and supplies it to the withdrawing households. Again, the quantity of currency is demand determined, which makes it difficult to argue that banks or the government can force households to hold more currency than they want. The withdrawing household, unless it stores the currency in its mattress, spends it, and someone else deposits that currency in another bank, which can then purchases reserve with it. Currency is a stand-in for check-writing — it should be ignored as the relevant quantity is the sum of deposits + currency, with the exact composition a function of household preferences for paying by cash or check.
So the government indeed ends up financing itself by printing money, getting the private sector to accept pieces of green paper in return for goods and services. And I think the MMTers agree that this would lead to inflation; I’m not clear on whether they realize that a deficit financed by money issue is more inflationary than a deficit financed by bond issue.
For it is. And in my hypothetical example, it would be quite likely that the money-financed deficit would lead to hyperinflation.
Why? Notice the logical break?
Somehow (unicorns?) borrowers will borrow more even though the interest rate has not changed, merely because banks have more reserves. Then, after borrowing more, they withdraw those funds as currency (again, for some unexplained reason). Then, once they borrow large amounts and take delivery as currency, they find themselves with more cash than they want. After that, instead of rationally re-depositing the cash, they decide to rush out and buy goods with this extra cash (which they didn’t want, but nevertheless decide to withdraw). Never mind how they will pay their loans back if they use the proceeds to purchase consumption. Never mind why they would withdraw cash if they didn’t want it. Never mind why they suddenly demand to borrow more at the same lending rate.
Now it is easy to make fun such an argument — it’s a great example of cognitive capture.
Basically, deep down, Krugman doesn’t really believe in a financial sector — he doesn’t believe in inside money.
He thinks all money is outside money, created by the central bank, and that there is a demand for this outside money that, in comparison with the supply provided by the central bank, determines the price level, rather than thinking of inside money, which is demand determined at the going rate. The real issue is the rate of interest, not the quantity of reserves. The real issue is private sector’s borrowing costs, not the how the government finances itself.
The non-financial sector doesn’t care how many reserves there are. It cares about borrowing rates and deposit rates. Neither the banks, nor government can force households to hold more deposits or currency than they want under a modern credit-based financial system. Rather, the government can force banks to hold whatever level of reserves it requires, and simultaneously the government can set any marginal price for those reserves. There is no reason why the marginal cost of reserves needs to fall if the quantity of reserves increases, as both the quantity of reserves and their marginal price are orthogonal policy variables. Typically, central banks set the marginal price and have the quantity of reserves be as small as possible. Some nations (e.g. Canada) set the quantity of reserves to be zero (actually, a few million) and only control the price. QE is an example of controlling both the quantity and price. You can have, btw, QE with a high and non-zero marginal price of reserves, simply by either paying banks a high level of interest on reserves, or imposing asset taxes on banks that force them to not lend money out unless a certain (pre-tax) return can be earned — enough of a return to pay the tax.